International Transactions and Currency Values

The Balance of Payments

Measures transactions in the current and capital accounts.

The Current Account

1. Merchandise trade - value of exports and imports
2. Service balance - value of exports and imports of services.
3. Unilateral Transfers - gifts and foreign aid to foreign interests.

The Capital Account

1. Short-term capital flows - purchase of financial assets in the money market with a maturity of less than one year. E.g. T-bills
2. Direct investments - refers to the purchase of property or the aquisition of ownership shares in order to control a foreign business.
3. Portfolio investments - purchases of securities to hold in order to receive interest, dividends or capital gains.

Direct investments and portfolio investments represent purchases of stocks, bonds and other financial assets with a maturity of over 1 year. - Capital market.

The BOP = 0

Since the U.S. runs a large current account deficit - over $200 billion in 1997 and expected to reach nearly $300 billion in 1998, there is an offsetting capital account surplus (with a bit of a fudge)

This makes the U.S. the world's largest debtor nation when looking at the difference between the value of U.S. fiancial assets held by foreign investors and the value of foreign assets held by U.S. investors.

Foreign investors are attracted to U.S. financial markets because:

• Develop production facilities in the U.S. to serve U.S. markets (reduce transporation costs) and to avoid import tariffs and quotas (the average U.S. tariff on imports is about 3.5%). However, the U.S. is more restrictive on auto imports.
• The U.S. is very stable politically and economically - this is a major attraction for foreign investors who can purchase U.S. Treasury debt with zero default risk.

If conditions change in the U.S. there could be the same capital flight that has plauged some of the developing countries. In this case we could expect:

• higher U.S. interest rates as the supply of loanable funds decreases
• A sharp devaluation of the dollar
• A reduction in the current account deficit as U.S. consumers purchase fewer foreign goods since the dollar has devalued. And U.S. goods become cheaper abroad.

Exchange Rate Determination

Foreign exchange markets are amoung the largest markets in the world with an annual trading volume in excess of $160 trillion

It is an over-the-counter market, with no central trading location and no set hours of trading.

Prices and other terms of trade are determined by computerized negotiation.

There are three markets for foreign exchange:

• Spot market - deals with currency for immediate delivery (within one or two business days)
• Forward market - involves the future (one, three or six months from today) delivery of foreign currency
• Currency futures and options market - deals in contract to hedge against future changes in foreign exchange rates.

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Simple model of spot market exchange rates using supply and demand

Current Account Factors

• Changes in relative inflation rates,
• Changes in tastes,
• Factors that determine comparative advantage.

Capital Account Factors

• Changes in interest rates

Exchange rates can be

• floating
• pegged
• floating peg

Floating exchange rates

Exchange rates are also affected by specualation  over future currency values. A currency that is considered undervalued brings forth buy orders.

The Forward Market for Currencies

Investors, businesses and other involved in foreign currency markets may want to guarentee the exchange rate that they will receive at some time in the future.

Take out a forward contract in the forward exchange market.

If the customer does not know if they will actually need the foreign currency, they can take out an option forward contract.

Methods of measureing and quoting forward exchange rates:

Outright rate - defines an exchange rate (e.g. ¥100 = $1)

Express the forward rate as a premium or discount from the spot rate, know as the swap rate.

Express the forward rate as an annualized percentage rate above or below the current spot rate

Functions of the Forward Exchange Market

Commercial Covering

For transaction of goods and services that are to be delivered in the future.

e.g. U.S. importer of Japanese radios agrees to pay ¥1 million for the shipment upon receipt in 30 days.

if current spot rate is ¥100 = $1, and stays constant, then will cost importer $10,000

Importer faces the risk that the dollar will depreciate.

Takes out a 30-day forward contract for the delivery of ¥1 million at the forward market rate of $.01/¥  (or ¥100 = $1).

When the  ¥1 million payment is due by the importer, the importer also takes delivery of the ¥1 million yen as given by the forward contract in exchange for $10,000. The
¥1 million  is then used to pay for the radio shipment.

Hedging of an Investment Position

Suppose there is a U.S.-based mutual fund (e.g. The Japan Fund) that purchases Japanese stocks and bonds for (primarily) U.S. investors.

The fund manager faces two types of risk:

• market risk - the value of his or her assets will decline,
  
• exchange rate risk - since the assets are denominated in yen, but the value of these assets are reported in dollars, a depreciation of the yen will reduce the NAV of the portfolio even if the yen value of the portfolio remains constant.

To reduce exchange rate risk, the fund manager can hedge with currency forwards.

Fund manager sells forward contracts of yen.

e.g. fear is that the yen will depreciate from ¥100 = $1

Manager sells forward contracts worth ¥1 billion ($10m) at exchange rate of ¥100 = $1.

When this forward contract matures, if the spot price of the yen has depreciated to ¥120 = $1, the fund can buy yen on the spot market and deliver them at the contract price of ¥100 = $1.

Will cost the fund manager $8.3 million to purchase ¥1 billion and then can sell yen for $10 million.

For a profit of $1.7 million on the foreign exchange transaction.

If the fund manager sells contracts in an amount that covers both principal and interest or dividends, then the manager has "locked in" their investment return regardless of which way exchange rates go.

If instead the yen were to appreciate, the currency trading losses are offset by the increased dollar value of the portfolio due to the yen's appreciation.

Speculation on Future Currency Prices

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